Corporate Debt

Corporate Debt

Article excerpt

A topic of some current interest to forecasters and policymakers is the extent to which the high levels of corporate indebtedness observed throughout the late-1980s contributed to the recession and whether the still substantial debts of the corporate sector are likely to make the recovery from recession slower than normal. The purpose of this note is to present and provide an interpretation of the evidence bearing on this issue.

That corporate debt was built up to historically high levels in nominal terms is illustrated by chart 1 which shows two measures of the nominal indebtedness of industrial and commercial companies (ICCs): net debt is a broad measure of company debt including debenture and loan finance and net trade credit as well as net indebtedness to banks, net liquid debt is bank advances less identified liquid assets. (Precise definitions are given in the appendix). Of more importance is the fact indicated in chart 1 that the level of debt when measured in real terms has also reached unprecedented levels in recent years.

Despite this substantial increase in the indebtedness of the corporate sector, current levels of company debt are not unprecedented when considered in relation to nominal output or to the value of the capital which provides the means of servicing the debt. Chart 2 shows the value of net debt relative to the market value of the ICC sector (as measured by their net financial liabilities) and to the measured value of the net capital stock at current replacement cost. This suggests that at the end of 1990 (the latest date for which figures are available) the level of corporate indebtedness in relation to the overall market value of ICCs is at about its average for the last twenty years. By contrast capital gearing indebtedness in relation to the measured value of the capital stock) has risen sharply throughout recent years although the level at the end of 1990 is not especially high by the standards of the past twenty years. The explanation for the more substantial rise in net debt in relation to the capital stock when compared with its rise relative to market value is that while a large proportion of capital accumulation has been financed by borrowing it has been accompanied by a rise in the market value of capital relative to its replacement cost: the valuation ratio has risen. The proximate cause of this is the steady rise in real equity prices throughout the 1980s shown in chart 3.

The viability of an individual company is best measured by the relation between its net debt and its overall value: if the company's debt is low relative to what the market believes it to be worth then it should not have much difficulty in raising any new finance that it might require. The evidence therefore suggests that the ICC sector as a whole is not in a serious financial state relative to recent historical experience. But there are at least three caveats to this. First the overall picture can mask severe problems for particular companies. That this is the case is well illustrated by the large number of company liquidations observed recently (see chart 4). Second there is a large degree of uncertainty surrounding estimates of the value of capital whether derived from direct estimates of the replacement cost of existing capital or indirect estimates based on the capital market valuations. If the capital stock has been overestimated since the last recession in 1981 because of under recording of scrapping at that time") then measured capital gearing will now underestimate the true level of capital gearing indicating that the true balance sheet position of the ICC sector is worse than the figures suggest. Third the satisfactory levels of aggregate corporate solvency rely on continued good performance from the stock market. Should equity prices fall sharply for one reason or another, the level of corporate debt will look large in relation to market valuations and this would cause problems in the refinancing of debt. …